As we discussed last month, we moved from an underweight position in developed market equities to a neutral position during July.
We do believe interest rates are at or a close to their peak, and the next shift for interest rates is down.
Investors have suddenly become bullish on equities and whilst we have a neutral position in both developed market and emerging market equities, we remain underweight Australian equities.
Complacency has reappeared and this concerns us.
There is no doubt that confidence has returned, but perhaps too much. Whilst interest rates are near their peak, which is a positive, the rally in the US market has been a narrow driven by the performance of the mega cap technology companies.
The chart below from Capital Economics illustrates how the top 5 have driven the S&P500. The top technology stocks have been referred to as the “magnificent seven” and have driven the US market, to an extent that we believe many need to temper their enthusiasm about the start of a broad market rally.
Indeed, we saw some retracement in the latter half of last month, particularly amongst the magnificent seven.
We do believe that small to mid-caps have been left behind in this rally, with a valuation gap that has not existed since the GFC, and this is the standout area in terms of valuation right now.
Every cycle is different and what is underpinning this cycle is low unemployment. The pandemic stimulus is also still underpinning economic resilience.
For the first time in eighteen months, we will only briefly mention inflation. US inflation has fallen from over 9 per cent to 3 per cent within twelve months, although core inflation is sitting around 5 per cent.
The Mastercard Economics Institute recently pointed out that whilst spending is exceeding income in the US, the level of spending is not only being supported by low unemployment but the savings levels that were built up during the pandemic are still assisting the economy as consumers draw down these higher levels of savings in household balance sheets.
Markets are starting to focus on the next trend for interest rates being lower and the bond market is starting to wake up to this. For the first time in years, we are positive on duration and believe above 4 per cent is a good buying opportunity. The risk is that the US Federal Reserve overstays its welcome and hikes further, throwing the growth cycle we are starting to see off course.
The Chart below from Zenith also highlights how the US Earnings – Bond Yield gap is back to GFC levels. We therefore expect the current retracement in equities to be mild and that bond yields will eventually start to fall. Whilst interest rates may well stay higher for longer than the market had been hoping, the next trend move in interest rates is lower.
We believe any pullback is a buying opportunity as the turbulence of the past 18 months will be behind us. The buying process will be gradual and determined by an assessment of the drivers of any pullback.
Whilst we are feeling more optimistic about the outlook, we are not entering another golden period for equities. The market will still be bumpy and stock selection will be critical to positioning a portfolio’s equities allocation.
Interest rates do matter but after eighteen months of central banks increasing official rates, another hike of 0.25% no longer matters to the same degree as rates are now at or near their peak.
As such we are now neutral across almost all risk-based assets, and we could soon be going overweight for the first time since January 2022.
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